September 10, 2009

Economists got it wrong, but why?

Economists definitely received some bad publicity this past week, most prominently in the New York Times, where Paul Krugman asked "How Did Economists Get It So Wrong?," a nonrhetorical question he goes on to answer this way:

"As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth… the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

"Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets—especially financial markets—that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don't believe in regulation."

"We are close to falling dangerously in love with the basic New Keynesian framework, the sticky price aspects of it in particular. Here is a simple observation: In the [statistical models] that are identified in the usual ways, inflation wants to drop like a rock in response to a basic technology shock. Models that engineer significant price inertia don’t want to let that happen…

One final point. In my time at the Fed, I have come to appreciate that most of the really important policy choices have nothing to do with Taylor rules or the like. They have to do with those episodes of financial crisis in which Taylor-like rules are woefully inadequate. Think here October 1987, the period from summer 1997 through the end of 1998, and the aftermath of September 11, 2001."

Though Professor Krugman spends a lot of time attacking acolytes of the so-called "Chicago" school, the fact is that the New Keynesian framework (described here by Greg Mankiw) is the workhorse theory within policymaking circles. If economists were unable to see their way to the macroeconomic consequences of the unfolding crisis, criticism needs to start with that framework.

I think such criticism is warranted, but the thrall of the New Keynesian world view has little to do with how "beautiful" the model is or that it is built on a lot of "impressive-looking mathematics." Quite the opposite. As I said in my 2005 comments, "the dynamics of the policy briefing game seem to favor forecasting performance over theoretical integrity." The models that we use for policy analysis are constructed on the basis of what connects with the facts we see (or think we see) in the data. If these models fail to contemplate things that might happen, it is precisely because there is a bias toward frameworks that explain history.

"The Economist’s briefing [criticizing the foresight of mainstream economists] also cited as an example of macroeconomic failure the 'reassuring' simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin's forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn."

Some attempts have been made to exploit the information contained in data from the Great Depression. (If you have patience for technical analysis you can find an example here.) And there have been many attempts to jerry-rig existing models to capture the financial shocks and their aftermath, especially once we had seen what that sort of reality looks like. But, by and large, the last year has been a data point we haven’t seen before, and it is not so surprising that models designed to capture the average quarter in the economy’s life would not do so well when very unaverage events arise.

It is certainly clear that the dominant pre-2007 strain of New Keynesian models was inadequate to the task that would confront us post-2007. That this was the case was not unknown. If I may quote myself again:

"I have in the past agreed that it is useful to think of the policy choices [following financial market events like the stock market crash of 1987] as policy shocks. I would still argue that today. But it sure would be helpful if at least some of these events would appear as something more than completely random disturbances. In other words, it would be very useful to have usable measures of what we loosely call 'financial market fragility,' and more useful still to have a coherent [sophisticated] quantitative model that captures them."

The problem with that prescription was that the relative infrequency of such events would likely have required us to step outside of our existing data-driven policy models and apply more theory, not less.

So does all this lead to the conclusion that we ought to ditch the presumptions of rationality and (largely) efficient markets, as Professor Krugman suggests? I have my doubts. Even some of the examples in the Krugman article seem to rely on the power of those ideas. In describing the problem of the lower bound of zero on nominal federal funds rates, he says this:

"During a normal recession, the Fed responds by buying Treasury bills—short-term government debt—from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback…

"But zero, it turned out, isn’t low enough to end this recession. And the Fed can't push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the 'zero lower bound' even as the recession continued to deepen, conventional monetary policy had lost all traction."

That whole story relies on a conventional monetary transmission mechanism, one that fundamentally plays off of efficient markets thinking.

In another passage from the New York Times article, we have this:

"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

"This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time…

"Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer…

"In short, the co-op fell into a recession."

That's a great example, but where is the irrationality? That tight monetary policy might cause a downturn in the economy may be absent from purely classical models, but it is dead center of the New Keynesian framework. The problem was that our mechanism for capturing monetary nonneutrality—essentially wage and price stickiness—was far too simplistic to capture the shocks that we were about to face (and that we arguably faced to lesser degrees during past financial market events).

In short, I accept the criticism that the dominant New Keynesian framework for forecasting and economic modeling needs some work (to say the least). I'm less convinced that we require a major paradigm shift. Despite suggestions to the contrary, I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live.

By David Altig, senior vice president and research director at the Atlanta Fed

Comments

Economists got it wrong because they only know how to model liquid markets. The fact that most markets are somewhat illiquid (that is, the decisions of participants frequently affect prices to varying degrees) means that the profession needs a major paradigm shift. The faults of modern economic models (including the New Keynesian models) were all described by Keynes in chapter 12 of the General Theory.

The Case-Shiller housing index was obviously a bubble and indicated to me that we had just experienced the largest misallocation of resources in the history of the world.

There were plenty of other signs early on ...inverted yeild curve, part time employment fell off a cliff and so on.

That so many economists didn't use some basic common sense is shameless. What happened was the equivalent of 99.9% of meteorologists telling everyone not to worry when Hurricane Katrina was 10 miles from landfall.

Anyway, I have an Economics degree, but work in the software field. I read econ blogs as a hobby and I predicted far better than the "professionals."

The scariest part is that now everyone who predicted it wouldn't happen is now saying it's over. They have kicked the can down the street with the stimulus and the bailouts, but we still don't have a clue what any big bank is worth or what is on the Fed/Treasury balance sheets.

I think there is still alot more pain ahead ...hope I'm wrong this time.

Modern macroeconomic models in the DSGE mould are all offshoots of the Arrow-Debreu model. There is no need for money in an Arrow-Debreu world and so they will never ever be useful for understanding a monetary-based economy. So I disagree with David, a paradigm shift is required. Robert Clower has expressed these ideas far more eloquently and powerfully in his address to the Southern Econonomic Association in 1993.

You are absolutely correct about the Taylor rule being the workhorse during normal times. Monetary policy is the tool of choice for micromanaging and making incremental adjustments to the economy.

The bigger problems and economic crises are NOT adequately addressed by monetary policy. Those who advocate ONLY the use of monetary policy are trying to fight the economic battles with most of the tools locked in the tool kit. Monetary policy loses traction as it approaches the zero bound. Monetary policy also loses traction as interest rates approach double digits. Monetary policy is too broad in its effects to target single sectors that are out of whack and cannot operate outside the normal bounds without creating unwanted distortions.

The largest risks of inflation are commodity inflation or shortages (oil shocks, housing bubbles, tech stock bubbles, etc.). Monetary policy is impotent for addressing these problems. Attempts to use monetary policy as a corrective cannot work because any policy will leave a negative impact on multiple sectors of the economy. Commodity inflation problems are narrow sector problems that are best addressed by regulations that can narrowly target the problem sector.

Oil shock- Carter fixed that with regulations requiring energy efficiency. Efficiency standards worked very well until efficiency standards were relaxed. Implementing new tougher standards and promoting alternatives going forward will prevent future oil shocks. Housing bubble: Ideological opposition to enforcing lending standards and sufficient collateral allowed the bubble to develop. Tech stocks, inadequate enforcement by SEC and inadequate transparency requirements. All of these problems could have and should have been addressed. However, we got the sorry excuse that nothing could be done. Something could have been done, but it meant admitting that Monetary-Policy-Only ideology is WRONG and that better use of targeted regulatory policy is necessary. The anti-regulation crowd is ignoring the fact that all economies operate under a set of rules and no set of rules is ever perfect. Rules need to be changed and ENFORCED to keep the "game" clean, promote transparency and fairness. Those who are trying to make excessive profits by gaming the system will always work to undermine fairness and transparency in the system because transparency and fairness are the enemies of gaming the system).

The battles prior to 1980 included wage-price spirals. Because of globalization, the US labor market is no longer capable of creating wage-price spirals. The old models that focus narrowly on national labor are inadequate for a global labor market. Commodity inflation and bubbles have replaced wage-price spirals as the enemy of stability. This needs to be acknowledged and the system adjusted to deal with current threats. We need to replace the old school anti-regulation crowd with new blood that understands how to create and implement good regulations.

Let's face it - economists rarely get anything right so it's hardly surprising that they failed to predict the financial crisis.

The underlying problem is that economies are wayyyy too complex to model effectively and truly understand. They cannot be predicted over any significant period of time any more than stock prices or the weather. Of course you won't find an economist who will actually admit that because their living depends on maintaining the fallacy that they know what's going on.

And so we must resign ourselves to a continual series of excuses - "We failed because we didn't take *this* factor into account. If only our models had fully offset *that* factor with *this*...". Blah, blah, blah ad infinitum. Truly a dismal "science", but one that will always be there due to the human propensity to try and see patterns and order where they don't exist.

OK, we all need to step back and remember that, when asking why the perspective of mainstream economics failed to do something we want it to do, we need to examine our own perspective, as well.

I have admired the work our host does since well before his arrival at the Fed. However, in this case, we have him saying "Look, the concerns outlined in a paper I wrote before this all happened got it right." Yes, and what a strong pull such success could have on one's own thinking. Strong enough,perhaps, that one might miss points others are trying to make. I, who have no such successful paper to attract my thoughts, saw Krugman's essay as largely a critique of our regulatory failure, rather than our central banking failure. If I read Krugman rightly, then saying that the Fed depends heavily on the New Keynesian model does not address what Krugman said. If you look at the effort to kill off regulatory oversight over the past decades, much of it does seem to rely on the excuse that market discipline will take care of limiting risk. Greenspan, who dominated policy making (at least in an advisory capacity) for a very long time, certainly took the "markets get it right" view, even if he was a New Keynesian when making monetary policy, and even if he stopped being a New Keynesian and became an Ad Hocian whenever disaster struck.

It strikes me that both the fresh-water/salt-water issue and the failings of New Keynesian thinking to account for liquidity and solvency problems need to be addressed. Room for both, because there are consequential failings associated with both.

Not that Anonymous was addressing Krugman, but Krugman did point out the failure of classical models to account for liquidity, and pointed out that other economic thinkers have taken into account the impact of capital depletion on the behavior or arbitraguers.

We should also avoid thinking along the lines of "Economists got it wrong because..." Economics is not monolithic, which is more or less the point of the exchange here and of Krugman's article. I also think there is good evidence that the biggest financial failure and recession since the Great Depression was not due to any one thing - not failure to understand the flow represented in the savings and investment equation, not failure to regulate, not failure to understand that risk doesn't go away when we ship it off to somebody else.

We did many things wrong. Each of us is likely to focus on one or two things, and that is to the good, within limits. Division of intellectual labor is likely to help us understand the individual facets of the crisis. What we need to avoid is the claim that our particular part of the puzzle was THE cause. It was THEM causes, not THE.

Blaming NeoKeynesianism without mentioning what caused NKians to rise to the fore--the pretense that the GUT of Economics had to be a Macro that conforms to the delusional Neoclassical principles*--is being careful to tell only half of the story. We could be nice and presume that is because you don't want to prove Krugman correct, but I'll decline that.

The pretense that group behavior is exactly identical to summing individual behaviors by the "freshwater" schools gave us the crime of NeoKeynesianism.

*The traditional wisecrack that the use of Neo- before an established branch of economics should be taken to indicate that the philosophy is the opposite of the original is noted for the record.

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